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Use threshold rebalancing to lower your portfolio’s risk

A powerful technique for controlling risk [10] in your diversified portfolio is threshold rebalancing.

Like other rebalancing [3] strategies, threshold rebalancing is used to prevent your asset allocation veering too far off-target due to the diverging returns of the assets [11] you hold.

There is endless debate about the ‘best’ rebalancing strategies and whether they can juice up returns.

It ultimately depends on future market conditions and the unique contents of your portfolio – in other words, whip out your crystal ball.

We therefore think it’s better for passive investors [12] with a broadly diversified [13] mix of equities and bonds to be aware of the rebalancing techniques available, and to choose a mix that best suits them.

I’ve already mentioned threshold rebalancing. The other main school of rebalancing is calendar rebalancing [14].

Calendar rebalancing is the simplest option – you just rebalance at the same time(s) every year, or every number of years.

However the threshold approach enables you to better fine tune your operations to take more control over costs and to reduce the impact of choppy markets [15].

Threshold rebalancing

Rebalancing occurs when threshold amounts are reached [16]

As the name implies, with threshold rebalancing you set asset allocation boundaries and then rebalance whenever they are breached, as opposed to automatically rebalancing your portfolio on a pre-determined date.

Picture a portfolio with a 50/50 equity/bond allocation.

The idea of threshold rebalancing is that you’re only forced to act when there’s a significant shift in your asset allocation.

You don’t tinker with tiny percentages that make little real difference, just because the calendar tells you to do so.

This can help to control trading costs, where applicable. In a fairly steady market you may not need to rebalance for a number of years, if you can live within a generous threshold.

The less you rebalance, the less you may pay out in trading fees. You could also save on taxes [7] (although ideally you’ll have squirreled everything away in ISAs and pensions, in which case you’re in a nicely tax-protected position already).

Choosing your threshold

The first step is to choose a threshold that suits your risk tolerance [17]:

Low threshold High threshold
Rebalance more often Rebalance less often
Portfolio sticks closer to target Drift to higher risk/reward assets
Suffer less volatility Some increase in volatility
Lower potential returns Higher potential returns
Higher costs of rebalancing1 [18] Lower costs of rebalancing2 [19]

N.B. Based upon the conclusions of various rebalancing studies, not a guaranteed outcome.

The obvious conclusion is that the more risk you can take, the higher you can afford to set your threshold, the greater your returns are likely to be, and the lower your costs.

Even a relatively high threshold still needs to offer a decent level of risk control. There are a number of different levels to choose from:

Common or garden thresholds
5% or 10% bands are routinely used by the financial services industry in threshold rebalancing, triggered whenever any asset’s proportion of the total portfolio rises or falls by 5/10%.

Tim Hale’s [20] risky/defensive manoeuvre
A 10% movement between aggregate risky and defensive asset classes is the rebalancing alarm bell. In other words, you act when the total number of equity assets in your portfolio swings 10% versus cash/bond assets.

William Bernstein’s [21] urbane subtleties
Rebalancing occurs when an asset moves 20% from its specific target. So if an asset’s target allocation was 20%, you rebalance when it strays out of a 16-24% range i.e. 20% of 20%. This is obviously a better approach than a straight 10% threshold, which is too clunky to deal with assets that occupy small niches in your portfolio.

Larry Swedroe’s [22] 5/25 rule
An even more subtle approach. Asset classes with a target allocation of 20% or more: rebalance when it moves by 5% versus the entire portfolio. Asset classes with a target allocation below 20%: rebalance when they drift by 25% in proportion to their target allocation.

Rebalancing ranges

You can refine your strategy still further by rebalancing towards a range, rather than strictly returning to an asset’s exact target allocation.

For example, let’s assume property occupies 20% of your portfolio with a range band of 5%.

If the asset drops 6% to 14% of your portfolio, you would only need to purchase an additional 1% to bring property back into your 15% to 25% tolerance band.

The idea of bands is to limit the costs you incur when rebalancing. If you only need to buy 1% worth of an asset class, then you may only have to sell one other asset in order to rebalance, for a total of two trades. Better still, you might be able to use new money [9] or divert dividend or interest income to the cause for a total of one trade. The method also reduces any capital gains tax liabilities [23] you may incur.

In contrast, if you rebalance to exact targets, then it is likely that whenever one asset requires rebalancing they all will, meaning more trades and potentially cost.

Proceed with caution, however. By only moving the asset back to the extreme of its range, there’s a reasonable chance you will have to rebalance again in the near future.

It may well be advantageous to make a bigger trade to return it back to the original target allocation, thereby potentially reducing the proportion of any trading commission payable, and the overall number of trades made.

Of course, swapping money from one index fund to another may well be costless these days (as opposed to if you’ve built your portfolio out of ETFs [24] or investment trusts [25], where you will certainly incur trading fees).

We rebalance the positions in our model Slow & Steady [26] portfolio for free, for example.

So time and the faff-factor may be more of an issue for many passive investors than costs nowadays.

Also keep in mind that you may be out of the market [27] for some time with a portion of your rebalanced funds, which is another potential (small) risk.

Hybrid rebalancing

The downside with pure threshold rebalancing is that it requires greater vigilance than calendar rebalancing. You have to check regularly that the thresholds have not been triggered.

One solution is to combine calendar and threshold rebalancing into one custom rebalancing strategy.

For example, you could decide that the portfolio will be rebalanced no more than annually but even then you will only intervene if an asset class has drifted by more than 20% in proportion to its target allocation.

Or you could decide to rebalance at least annually, but also to intervene if any asset deviates by more than 5% from its target during the year.

US index fund giant Vanguard [28] has researched the rebalancing question and concluded [29]:

“The relatively small differences in risk and return among the various rebalancing strategies suggests that the rebalancing strategies based on various reasonable monitoring frequencies (every year or so) and reasonable allocation thresholds (variations of 5% or so) may provide sufficient risk control relative to the target asset allocations for most portfolios with broadly diversified stock and bond holdings.”

So don’t drive yourself around the bend trying to find the ‘best’ rebalancing technique. Experiment with the options to find your own strategy that balances your personal risk tolerance against the administrative effort and potentially the costs of rebalancing.

Take it steady,

The Accumulator

Series NavigationThe simplest way to rebalance your portfolio [8]Rebalance with new contributions to save on grief and cost [9]
  1. May or may not be applicable, depending on the trading costs of your chosen funds and strategy. [ [32]]
  2. May or may not be applicable, depending on the trading costs of your chosen funds and strategy. [ [33]]